Monthly Archives: October 2012

Nuokang (NKBP) going private

While the going private transaction of China Mass Media hasn’t yet completed (it is progressing as planned) another Chinese company announced that it reached a definitive agreement for a going private transaction last week. The CEO of China Nuokang Bio-Pharmaceutical is offering $5.80 in cash ($5.75 effectively after a $0.05 ADS cancellation fee). The deal is expected to close in the first quarter of 2013, and with the stock currently around $5.30 a successful transaction could offer an ~8.3% absolute return and an IRR of ~19.4% (assuming a close on the last day of the quarter).

My view on going private transactions in China in general

Everybody is these days aware of the risks related to investing in Chinese companies, and that is exactly the reason why I’m interested in this corner of the market (see also my investment in DSWL). With all US listed Chinese companies trading at depressed valuations you have to figure that there are some real companies out there that are trading significantly below fair value. And given the scale and sophistication of the fraud there are just a few parties in a position to capitalize on the opportunity. The exception are of course insiders: they know perfectly well that they are buying, so you would expect that the management of legitimate companies will try to take their company private if they are in a position to do so.

I think that this is exactly what we are seeing today. Besides the large number of Chinese companies that went to zero there are also a decent number that already went private, or are in the process of going private. Besides the subject of this post and China Mass Media you currently also have:

  • Yucheng Technologies
  • Fushi Copperweld
  • Winner Medical Group
  • Pansoft
  • China Transinfo Technology Corp
  • Gushan Environmental Energy

These deals trade in general at a above average spread compared to merger deals in the rest of the world, and the question is of course if this is correctly pricing in a higher risk or if investors are simply burned by their experience in investing in China.

One thing to consider is that undertaking a going private transaction does not accomplish much if you are running a fraudulent company. You can’t complete it, and starting the process and then not completing it doesn’t do you any good either. There are of course always some angles to consider: you can manipulate the stock price and gain through illegal insider trading, or maybe you could transfer money out of the company using a break-up fee. But I think that in most cases something like that would be an unnecessary complex and inefficient way to commit fraud. So I would say that logically a going private proposal from a Chinese company should indicate that management is motivated to complete the transaction.

I wouldn’t blindly buy the above basket. A going private proposal is a good hint that the company is real and that management wants to complete the transaction, but I would want to see that there are no major red flags in the financials (especially w.r.t. issuing debt, raising equity or insiders selling shares). Besides a management that is motivated to complete the transaction, you also want to see that they have the financing to get the deal done. Shareholder approval could also be a roadblock, and last but not least: you do want a sufficient expected return.

China Nuokang Bio-Pharmaceutical

Enough chitchat: time to take a deeper look at Nuokang. The company went public at the end of 2009 (prospectus) and describes itself as follows:

China Nuokang Bio-Pharmaceutical Inc. is a leading, fully integrated, profitable biopharmaceutical company focused on researching, developing, manufacturing and marketing hematological and cardiovascular products.  We sell a portfolio of fourteen products, which includes principal products Baquting®, a flagship hemocoagulase, and Aiduo®, a cardiovascular stress imaging agent. Our product pipeline includes product candidates under development in hematological, cardiovascular and cerebrovascular disease diagnosis, treatment and prevention.

Developed in-house and launched in 2001, Baquting, our flagship product, is China’s leading hemocoagulase for the treatment or prevention of bleeding. Through September 30, 2009, we had sold an aggregate of over 38 million units of Baquting to our end-customer base of over 2,400 hospitals across China.

The short public history of the company makes a fraud evaluation harder. Positive is that insiders haven’t sold a share since the public offering (literally!). The CEO, Baizhong Xue, owned 94,508,704 shares after the IPO (representing 60.02% of all shares) and he owns the same number today (now representing 61.2%). Neil Nanpeng Shen, a board member and managing partner of Sequoia Capital China, has controlled 20.1M shares since the IPO representing another 12.77% of shares. As a group insiders own 74.6% of the company today. Another positive sign is that the IPO wasn’t used to cash out insiders, but to raise cash for the business. The CEO sold less than one percent of his shares in the IPO.

The debt side of the story also looks good. The amount of short term debt on the books has decreased the last years and the amount of long term debt has been almost non-existent. Unfortunately the company has never paid out a dividend (I like to see that: it’s an unfakeable cash flow back to shareholders). That said: I don’t think there is a pattern here that indicates that management is trying to get rich by raising money.

Related party transactions are another specific area of concern because these offer the potential for unfair deals at the expense of shareholders. Nuokang seems squeaky clean here, in the latest 20-F only the following was reported:

Transactions with Mr. Baizhong Xue

From time to time, Mr. Baizhong Xue, our chairman and chief executive officer, has extended loans to us and paid business-related expenses on our behalf. We from time to time make advances in respect of business-related expenses incurred by Mr. Xue on our behalf. As of December 31, 2009, 2010 and 2011 amounts due to Mr. Xue were nil, nil and nil, respectively.

Loans and Guarantees

In March 2009, Dengzhou Credit Union extended to us a short-term loan of RMB3.0 million at the interest rate of 7.7%. In September 2009, Industrial Bank Co., Ltd. and China Merchants Bank extended to us short-term loans of RMB60.0 million and RMB15.0 million, respectively, each at an interest rate of 6.372%. While these loans were secured by certain of our property, plant and equipment or land use rights, Mr. Baizhong Xue, our chairman and chief executive officer, also provided guarantees for all these loans. As of December 31, 2011, these loans have all been repaid.

So don’t see any major red flags here w.r.t. fraud, and it seems very logical that a company that is already majority owned by the CEO is going private. If the 13E3 filing can be trusted the CEO does have the necessary financing to take the company private (he needs ~$44M). Don’t think shareholder approval is going to be a problem either: as far as I can tell there is no majority of the minority provision. Nuokang Bio-Pharmaceutical is, just as China Mass Media, domiciled in the Cayman Islands, and only two-thirds of the shares need to vote in favor of the transaction. With Mr. Xue owning 61.2% that doesn’t seem to be a difficult threshold…

Pursuant to the merger agreement, Anglo China and Britain Ukan, companies controlled by Mr. Xue, agreed to vote all of the Shares beneficially owned by them in favor of the authorization and approval of the merger agreement, the Cayman Plan of Merger and the transactions contemplated thereby (including the merger). Mr. Xue beneficially owns approximately 61.2% of the total outstanding Shares.


Investing in China is not without risks, but in this case I think I’m getting paid well for taking the risk. I don’t see anything in China Nuokang Bio-Pharmaceutical history that raises a big red flag, and there also doesn’t seem to be a whole lot that can stop the transaction from going through. Combine that with a wide spread between the offer price and the market price and you have, what looks to me, a nice opportunity.


Author is long China Nuokang Bio-Pharmaceutical

Quick Conduril update

I have been mailing a bit with a reader about Conduril the past few days, and I have to credit him for most of what you will be reading here. The first interesting discovery is that Conduril does in fact distribute interim reports (only in Portuguese), although they are not published online on their website or on the site of the Portuguese securities regulator. I have uploaded a copy here, and updated the table with financial information to include the results of the last half year:

Results for the first half of 2012 have been solid and are roughly on the same level as last year. The Interim Report did not include a cash flow statement, and it’s a bit too much work to try to piece it together from the income statement and the balance sheet, but although the cash balance is growing the liquidity position of the company is not improving. Short term debt went from €37.7M to €52.2M and the net cash position from the company went from -€6.3M to -€16.7M.

Positive is that the order book is still growing and is now standing at €700M versus €600M at the start of this year. Conduril has currently €100M worth of projects in Portugal (just 14%),  €380M sits in Angola (54%) and  €220M of orders are in other foreign countries (32%). The company scored new orders in Congo and Senegal this year: two countries where Conduril has not been active before.


Author is long Conduril

AssuranceAmerica going private

AssuranceAmerica Corporation (ASAM) announced a going private transaction (SEC filing) where it will perform a reverse/forward stock split to cash out shareholders owning less than 10,000 shares at $0.04/share. Although the stock is extremely illiquid I was able to pick up some shares at $0.033 for a ~$70 +EV bet.



Special Opportunities Fund (SPE)

The Brooklyn Investor published an interesting write-up on the Special Opportunities Fund (SPE) that caught my attention, and also Whopper Investments attention. SPE is run by a hedge fund manager that specializes in investing in closed-end funds, and applying activism were necessary to unlock value. This is also how SPE was formed: Bulldog Investors won a proxy contest in 2009, and gave shareholders the option to cash out at a price close to NAV. At the same time the objective of the fund was changed. From the 2009 semi-annual report:

What do we envision for the future of the Fund? The name change we are proposing – Special Opportunities Fund – says it all. The principals of Brooklyn Capital Management, our newly formed investment advisory firm, include Steven Samuels, Andrew Dakos and me. We have a long history of opportunistic investing, primarily through hedge funds managed under the Bulldog Investors name. Since its inception almost seventeen years ago, our original hedge fund, Opportunity Partners L.P. has generated an annualized return of 12.8% vs. 7.4% for the S&P 500 Index. It has incurred a loss in only one of those years.*

We are generally value investors. Our bread and butter is investing in closed-end funds. I have personally been investing in closed-end funds for thirty-five years. However, we have also invested opportunistically in a number of other areas. In certain instances, we have employed activism to unlock the value of our investments. Unlike many other managers who are tethered to a benchmark, we are not interested in making an investment unless we perceive that we can get an edge. After the tender offer, we intend to apply this “edge” philosophy to managing the Fund.

So we get a manager that has a good track record, and they are applying a strategy that makes a lot of sense. From the 2012 semi-annual report:

Liberty All-Star Growth Fund (ASG) and Liberty All-Star Equity Fund (USA)

We purchased most of our shares of these well diversified multi-manager equity funds at a double-digit discount to net asset value. Each fund makes cash distributions of 1.5% per quarter (6% per annum). After extensive discussions with the manager about their discounts, on June 26th ASG launched a self-tender offer for 25% of its shares at a 5% discount to NAV. As a result, the discount narrowed to under 8% and we opportunistically sold some of our shares before the tender offer expired. We tendered the balance and the Fund accepted almost 80% of our shares, a surprisingly high percentage. Since we saw a low probability of further alpha by holding, we subsequently sold our remaining shares of ASG in the market at a single-digit discount. USA’s discount, on the other hand, is still greater than 10% and therefore we have continued to accumulate shares. We intend to resume discussions with management about USA’s discount in the near future.

Besides the example above the same semi-annual report provides plenty of other examples of investments the company is making, the rationale for making them, and what they are doing to unlock value. So unlike most closed-end funds I think there is a good probability that they are indeed creating value. Having a track record is good: doing something that logically makes sense is even better.

Capital structure

The capital structure of the SPE fund is what really got my attention. The fund completed a rights offering this summer for a new class of convertible preferred stock:

…on July 23, 2012 the Fund finally completed an innovative rights offering for a new class of convertible preferred stock at a price of $50 per share. The offering was significantly oversubscribed. The aggregate number of shares issued was 749,086 for which the Fund received a total of $37,454,300 in cash. The converts have been trading slightly above the issue price and we think that is an indication that we got the terms about right. To summarize the basic terms, each convert (1) is entitled to receive a quarterly dividend of $0.375 per share or 3% per annum; (2) is convertible into 3 shares of common stock (subject to adjustment for distributions); (3) will be redeemed in five years at $50, and (4) is callable if the net asset value of the common stock reaches $20 per share (subject to adjustment for distributions).

To be honest: I don’t understand why the convertible preferred stock was created. It seems to be unnecessary complex without significant upside for the common. While all the downside remains with the common the upside is shared almost completely with the preferreds. The flip side of this story is that the preferreds are already callable if NAV grows with just 10%, so it could easily be that they will be called within a year. So why increase the size of the funds assets in such a temporary and volatile way?

The latest reported NAV/share of SPE is $17.68/share while the common shares are trading at $15.81 and the preferreds at $52.00. This means that the common is trading at a bit more than a 10% discount, and it is possible to buy the common without almost no downside risk at $17.33/share. You don’t know how long you don’t have no downside risk since the preferreds are callable at a $20 NAV/share, but unless SPE starts trading at a huge discount this is always a favorable outcome. And while waiting for this positive scenario you will be paid $1.5 in interest a year and you know that no-matter what: you will be repaid at par in 5 years time.

To properly evaluate the value the preferreds you need to create a Monte Carlo simulation. The reason for this is that the path that the asset value takes is very important for the value of the preferreds. You could have two scenario’s where after five years the total growth in NAV is zero, but if in one case NAV briefly hit $20/share in the first year the preferreds will be (or should be) called early while in the other case the preferred owner is going to enjoy five years of interest.

Since I hadn’t programmed anything in a long time this seemed like a fun exercise. I have modelled the growth of the asset value using geometric Brownian motion. This basically means that the value takes a random walk with a certain drift (the expected growth rate) and a certain variance (I used the historical variance of SPE for the past year).

The key part of the simulation, written in Python, is listed below and should be fairly straight forward to understand even if you aren’t a programmer. The full source code of the program can be found here if you want to play around with different assumptions. Simulation results are written to a .csv file that you can open in Excel.

def motion(NAV):
    steps = 0
    dividend = 0

    while steps<stepsMax:
        # random drift of asset value
        drift =  (mu - 0.5 * vol * vol) * dt
        uncertainty = vol*sqrt(dt)*standard_normal()
        NAV *= exp(drift+uncertainty)

        # check if dividend needs to be paid
        dividend += dDiv
        if dividend >= (dDiv*days/4):
            NAV -= dividend
            dividend = 0

        # check if prefs can be called
        if (NAV-dividend) > callNAV:
            NAV -= dividend
            return (NAV, steps)

        steps += 1
    # prefs not called
    NAV -= dividend
    return (NAV, steps)

Technically geometric Brownian motion is not completely correct to describe asset prices because it assumes constant variance and uses a normal distribution, but it’s a reasonable approximation to get an idea of the range of outcomes. Besides the variance a key input of the simulation is what you think the expected growth rate of the asset base is. The lower it is the higher the probability that the preferreds will not be called, and the higher the relative attractiveness of the preferreds.

The three graphs below show after how many days you can roughly expect that the preferreds will be called assuming a 5% growth rate, a 7.5% growth rate and a 10% growth rate. Number of simulation trials was 10.000:

As you can see the higher the growth rate the shorter the average number of days the preferreds remain outstanding. If the preferreds remain outstanding longer than 773 days (a bit more than three years, using 252 days/year) they will always outperform the common. The reason is that you can buy three shares using the preferreds at $52 or three normal shares at $15.80 each. The $4.60 price difference is roughly equal to three years in interest payments.

On average the preferreds are expected to underperform the common because even with just a 5% growth rate the preferreds will be called within three years ~78% of the time and with a 10% rate the probability goes up to 90%. This is obviously not the complete picture: it also matters how much the preferreds underperform or outperform in the various scenario’s and how much risk they have. The following graph should provide some insight into this question. What you see here are average annualized returns weighted by the number of days before the preferreds are called.

The preferreds

While the preferreds are extremely low risk you are also not getting a great return. The reasons for this are: 1. the preferreds are trading above par, 2. when the preferreds are called NAV/share is diluted and 3. I’m assuming that after the conversion the common is still trading at a 10% discount. You do get an option on the discount of SPE shrinking with the preferreds because how valuable the conversion is depends on the discount of the common while the callable date depends on the underlying NAV.

I do think that relatively speaking the preferreds are a good deal. There is a huge amount of excess collateral, and if this would be rated it probably deserves an AAA-rating. And a return of >2% a year for debt with a maturity below five year, and most likely around one year is a good deal. And you do get an option on the discount shrinking as well. I just don’t find it attractive from an absolute return perspective.

The common

One thing about the returns of the common in the above graph that should catch your attention is that the weighted average IRR is lower than the underlying growth rate. For returns below 3% this is logical: here the assets don’t return enough to service the dividends for the preferreds, so you do have leverage to the downside.

The real problem is that the conversion of the preferreds dilutes common shares. If NAV grows with 10% from 158M to 174M the preferreds are callable because (174M – 37M) / 6.809.867 > $20. But if this happens you have 174M in NAV and 6.809.867 + 749.086 * 3 = 9.057.125 shares. This would result in a NAV of ~$19.20/share, and with a 10% discount you have a value of $17.30 remaining. With the stock at $15.80 today the 10% growth in NAV would result in a return of ‘just’ 9.4% for common shares (this is ignoring any dividends that are paid in the time it took to generate this return).


At first sight it’s a weird result: but I think the discount is the key to understanding what is happening. The current discount should already account for the highly likely future dilution, and when the preferreds are converted the discount should shrink. By assuming that the discount remains constant – at first sight a reasonable assumption – you are effectively assuming that it is growing. This should boost the expected returns of both the preferreds and the common stock.

If the stock is trading at a 10% discount before the conversion NAV/share is diluted by 3.84%. The probability of this dilution happening is, depending on the growth rate, between 80% and 90% if I can trust my simulation results. So it’s probably fair to say that after the dilution the discount should shrink from the current 10% to ~7%. If we generate a new average return graph based on this assumption we get this:

In this case both the returns of the common and the preferreds are higher. The common does have leverage to both the upside and the downside, and the preferreds are a bit more sensitive to the underlying growth rate. The expected return of the preferreds is no longer an almost flat line.


If there is one thing to take away from all my ramblings: at today’s prices you are not truly buying SPE at a 10% discount. Part of this discount (my guess: ~3%) is simply representing the possible future dilution from the preferreds, and because these are trading above par they don’t offer an easy way to profit.

SPE or SPE-P might still be an attractive investment: in the grand scheme of things a discount that is a few percentage points bigger or smaller is no big deal. And while I have talked little about my perspective on the cost structure of SPE or their strategy in this post (it is already long enough as it is), I do mostly agree with The Brooklyn Investor and Whopper Investments about the attractiveness of the fund.

I haven’t yet made up my mind if I should buy SPE, or maybe SPE-P. Another option is to piggyback some of the funds holdings. Their latest semi-annual report is a goldmine filled with cheapish funds that do have a potential catalyst. To be continued…


No position in SPE or SPE-P, might initiate one in the future